A bright spot in housing’s bad market: Rentals

Housing bear David Rosenberg says that apartment REITs should continue their streak for the foreseeable future.

At a time when virtually all things real estate have been distressed, there’s one corner of the sector that has been fruitful for investors. Many factors working against the residential housing market have actually helped returns on real estate investment trusts.

REITs — which invest in commercial properties from office buildings to shopping malls, as well as rental apartments — have outperformed the S&P 500 since the financial crisis. Total returns for REITs were 28% in both 2009 and 2010, besting the S&P 500, which returned 23% and 15%, respectively, according to the National Association of Real Estate Investment Trusts, the industry trade organization. Though the gains in REITs are still 20.84% below their February 2007 peak, their performance is impressive.

Indeed, a few factors make REITs especially attractive, even with the fragile economic recovery. For one, prices for REITs don’t necessarily move in tandem with the broader stock market. They tend to rise and fall with the commercial property market. And because a REIT (by law) must distribute at least 90% of its income to shareholders, the investments pay relatively high dividends.

The returns from apartment REITs are due in large part to a housing market still in disarray — and they might just continue being a wise investment, given the grave market for buying single-family homes.

While home prices have fallen by 26% since their peak in June 2006 and are forecast to lose another 5% to 10%, the rate at which rentals sit empty has dropped to its lowest level in seven years, says Gluskin Sheff chief economist and strategist David Rosenberg. Vacancies dropped from 11.1% during the three months ending in September 2009 to 9.4% during the three months ending in December 2010, he says.

“Level of demand is anemic,” Rosenberg says of buying, predicting that there will be many more renters in the future as a true housing recovery is far off.

A few factors continue to work against the housing market, making renting versus buying for many a more appealing option. The National Association of Homebuilders reported earlier this week that sales of previously occupied homes rose slightly in January by 2.7%, from a seasonally adjusted annual rate of 5.22 million in December to 5.36 million in January. But it doesn’t necessarily portend a housing rebound. Foreclosures represented 37% of sales in January. And 32% of the home sales were all-cash transactions — double the rate from two years ago and a sign that a growing number of purchases are being made by investors, the group reported. Moreover, sales of new homes dropped by 11.2% from December to January, according to the government.

For one, financing will be hard to come by. Rosenberg says one-third of Americans have FICO scores below 660 and most lenders won’t give a Federal Housing Administration loan to anyone with a score below that. In fact, the average FICO score for a new FHA loan is around 700, up from 630 a year ago, according to Rosenberg. Also, he expects the U.S. Treasury to recommend increasing the down payment requirement for new FHA loans from 3% to as high as 7%.

Demographic trends are also working against single-family homes, Rosenberg adds. Many who bought too much house want to scale down. Empty nesters will increasingly opt for smaller bungalows. And when it comes to younger buyers, many 20-somethings are unable to qualify for loans given today’s record-high unemployment rate and massive student debt burdens.

It’s anyone’s guess how the grim forecasts will play out. But if investors are looking to invest in real estate, apartments might still be an option.